It may be that the market downdrift we’ve been experiencing since early October started out as a bout of yearend mutual fund selling, as I’ve been writing for a while. Maybe not. In any event, the selling has continued for far longer than the mutual fund hypothesis can explain.

It may be that the market has been thinking that the prices of IT-related shares had gotten far too high, given their earnings prospects. Strike out the “far” and I’d have to agree; in my mind, the big issue preventing at least a temporary market rotation away from tech has been, and remains, what other group to rotate into.

It’s also possible that the operative comparison has been between stocks and bonds. The ongoing upward yield curve shift now has short-term Treasury notes yielding around 2.5% and the 10- and 30-year yielding above 3%. Arguably this is a level where income-hungry Baby Boomers could feel they should allocate somewhat away from stocks and into fixed income.

Whatever the market’s motivation, however, I’m sticking with my idea that the S&P bottomed on October 29th.

Many times, when the market has hit a low and has begun to rebound, it will reverse course to “test” the previous low. Also arguably, that’s what has been happening over the past week or so–formation of what technicians in their arcane lingo call a “double bottom.” The main worry with this idea is that two weeks after the initial low is an unusually short time for the double bottoming to be happening. Still, it’s my working hypothesis that this is, in fact, what’s going on.

The things to monitor are whether the market breaks below the late October low and, if so, whether it breaks below the April or February lows.

Another topic: oil. Crude oil and oil stock prices have been plunging recently. Most non-US producers added extra current output to offset the assumed negative impact of the US placing renewed sanctions on the purchase of oil from Iran. At the last minute, however, Washington granted exceptions to large purchasers of Iranian crude. Because of this, oil has continued to flow in addition to the extra oil from OPEC. Since demand for oil is relatively inflexible, even 1% – 2% changes in supply can cause huge changes in price. Whether or not the US deliberately set out to deceive OPEC and thereby cause the current oversupply, the price of oil is down sharply since the US acted.

Saudi Arabia and Russia have just announced supply cuts. Given that Feb – April is the weakest season of the year for oil demand, it’s not clear how long it will take for the reductions to lift the oil price. It seems to me, though, that the more important question is when rather than if. So I’ve begun to nibble at US shale oil producers that have been flattened since Washington’s action.

Over the past year the price of a barrel of crude oil has risen from $50 to $80. The latter figure is substantially below the $100+ that “black gold” averaged during 2011-2014, but hugely higher than the low of $25-minus thee years ago.

conventional wisdom upended

Two pieces of conventional wisdom about oil have changed during the past half-decade:

–effective shale oil production technology has shelved the previous, nearly religious, belief in the near-term peaking of world oil productive capacity. More than that,

–the development of viable electric cars has won the world over to the idea that a substantial amount of future transportation demand is going to be met by non-petroleum vehicles.

new meaning for “peak oil”

The “peak oil” worry used to be about the day when demand would outstrip supply (as emerging economies switch from bicycles/motorcycles to several cars per household–just as conventional oil deposits would begin to give up the ghost). The term now means the day (in 2040?) when demand hits a permanent peak, and then begins to fall as renewable energy supplants fossil fuels.

new OPEC solidarity

When Saudi Arabia, the most influential member of OPEC, said during the recent supply glut that its target for the oil price was $80 a barrel, I thought the figure was much too high. Why? I expected that the cartel wouldn’t stick to mutually-agreed output restrictions (totaling 1.8 million daily barrels) for the years needed for oversupply to dry up and the price of output to rise. That was wrong.

I think the main reason for OPEC’s uncharacteristic sticktoitiveness (first time I ever typed that word) is the realization that petroleum is going to yield to renewables as firewood was supplanted by coal in the mid-nineteenth century and coal was replaced by oil in the mid-twentieth.

There are other factors, though. The collapse of the Venezuelan government means that country now produces about a million barrels a day less than two years ago. Also, Mr. Trump’s aversion to all things Obama has prompted him to pull the US out of the Iranian nuclear agreement and reinstate an embargo. This likely means some fall in Iranian output from its current 4.5 million or so daily barrels, as sanctions go back into effect. Anticipation of this last has upped today’s oil price by something like $10 a barrel.

adding 600,000 barrels to OPEC daily output

Just prior to the Trump decision on Iran, Russia and Saudi Arabia were suggesting publicly that the coalition of oil producers eventually restore as much as 1.5 million barrels of daily production, as a way of keeping prices from rising further. Mr. Trump has reportedly asked the two to make any current increase large enough to offset the $10 rise his Iran action has sparked.

Unsurprisingly, his plea appears to have fallen on deaf ears. Last Friday the cartel announced plans to put 600,000 barrels of daily output back on the market–subject, I think, to the condition that the amount will be adjusted, up or down, so that the price remains in the $75 – $80 range.

optimizing revenue

The old OPEC dynamic was Saudi Arabia, which had perhaps a century’s worth of oil reserves and therefore wanted to keep prices steady and low vs. everyone else, whose reserve life was much shorter and who wanted the highest possible current price, even if that hastened consumers’ move to alternatives.

Today’s dynamic is different, chiefly because the Saudis now realize that the age of renewable energy is imminent. Today all parties want the highest possible current price, provided it is not so high that it accelerates the trend to renewables. The consensus belief is that the tipping point is around $100 a barrel. $80 seems to give enough safety margin that it has become the Saudi target.

For almost a year I’ve owned domestic shale-related oil stocks, for several reasons:

–the dire condition of the oil market, oversupplied and with inventories overflowing, had pushed prices down to what I thought were unsustainable lows

–other than crude from large parts of the Middle East, shale oil is the cheapest to bring to the surface. The big integrateds, in contrast, continue to face the consequences of their huge mistaken bet on the continuance of $100+ per barrel oil

–there was some chance that despite the sorry history of economic cartels (someone always sells more than his allotted quota) the major oil-producing countries, ex the US, would be able to hold output below the level of demand. This would allow excess inventories to be worked off, creating the possibility of rising price

–the outperformance of the IT sector had raised its S&P 500 weighting to 25%, historically a high point for a single sector. This suggested professional investors would be casting about for other places to invest new money. Oil looked like a plausible alternative.

I’d been thinking that HES and WPX, the names I chose, wouldn’t necessarily be permanent fixtures in my portfolio. But I thought I’d be safe at least until July because valuations are reasonable, news would generally be good and I was guessing that the possibility of a warm winter (bad for sales of home heating oil) would be too far in the future to become a market concern before Labor Day.

Iranian sanctions

Now comes the reimposition of Iranian sanctions by the US.

Here’s the problem I see:

the US imposed unilateral sanctions like this after the Iranian Revolution in 1979. As far as oil production was concerned, they were totally ineffective. Why? Oil companies with access to Iranian crude simply redirected elsewhere supplies they had earmarked for US customers and replaced those barrels with non-Iranian output. Since neither Europe nor Asia had agreed to the embargo, and were indifferent to where the oil came from, the embargo had no effect on the oil price.

I don’t see how the current situation is different. This suggests to me that the seasonal peak for the oil price–and therefore for oil producers–could occur in the next week or so if trading algorithms get carried away, assuming it hasn’t already.

Two factors are moving the Energy sector higher. The obvious one is the higher oil price during a normally seasonally weak time. In addition, though, the market is actively looking for alternatives to IT. It isn’t that the bright long-term future for this sector has dimmed. It’s that near-term valuations for IT have risen to the point that Wall Street wants to see more concrete evidence of high growth–in the form of superior future earnings reports–before it’s willing to bid the stocks significantly higher. With IT shunted to the sidelines for now, the market is not being a picky as it might be otherwise about alternatives such as Energy and Consumer discretionary.

The fancy term for what’s going on now is “counter-trend rally.” It can go on for months.

As to the oils,

–a higher crude oil price is clearly a positive for the exploration and proudction companies that produce the stuff. In particular, all but the least adept shale oil drillers must now be making money. This is where investment activity will be centered, I think.

–refiners and marketers, who have benefitted from lower costs are now facing higher prices. So they’re net losers. Long/short investors will be reversing their positions to now be short refiners and long e&p.

–the biggest multinational integrateds are a puzzle. On the one hand, they traditionally make most of their money from finding and producing crude. On the other, they’ve spent very heavily over the past decade on mega-projects that depend for their viability on $100+ oil. This has been a horrible mistake. Shale oil output will likely keep crude well short of $100 for a very long time.

Yes, the big multinationals have all taken significant writeoffs on these ill-starred projects. But, in theory at least, writeoffs aren’t supposed to create future profits. They can only eliminate capital costs that there’s no chance of recovering. As these projects come online, they’ll likely produce strong positive cash flow (recovery of upfront costs already on the balance sheet) but little profit.

The question in my mind is how the market will value this cash flow. As I see it–value investors might argue otherwise–most stock market participants buy earnings, not cash generation. Small companies in this situation would likely be acquired by larger rivals. But the firms I’m talking about–ExxonMobil, Shell, BP…–are probably too big for that. Will they turn themselves into quasi-bonds by paying out most of this cash in dividends? I have no idea.

Two thoughts:

—–why fool around with the multinationals when the shale oil companies are clear winners?

—–as/when the integrateds start to show relative strength, we have to begin to consider that the party may be over. So watch them.

Investors who are not oil specialists typically use (at most) two crude oil prices as benchmarks:

—Brent, a light crude from under the North Sea. Today it is selling at just about $70 a barrel. “Light” means just what it says. Brent is rich in smaller, less-heavy molecules that are easily turned into high-value products like gasoline, diesel or jet fuel. It contains few large, denser molecules that require specialized refinery equipment to be turned into anything except low-value boiler fuel or asphalt. Because it can be used in older refinery equipment that’s still hanging around in bunches in the EU, it typically trades at a premium

—West Texas intermediate, which is somewhat heavier and produced, as the name suggests, onshore in the US. It is going for just under $64 a barrel this morning.

What’s remarkable about this is that we’re currently nearing the yearly low point for crude oil demand. The driving season–April through September–is long since over. And for crude bought, say three weeks from now, it’s not clear it can be refined into heating oil and delivered to retail customers before the winter heating season is over.

Yet WTI is up from its 2017 low of $45 a barrel last July and from $57 a barrel in early December. The corresponding figures for Brent are $45 and $65. (Note that there was no premium for Brent in July. I really don’t know why–some combination of traders’ despair and weak end user demand in Europe.)

why the current price strength?

Several factors, most important first:

–OPEC oil producers continue to restrain output to create a floor under the price

–they’re being successful at their objective, as the gradual reduction of up-to-the-eyeballs world inventories–and the current price, of course–show

–the $US is weakening somewhat.

My Lighting class is calling, so I’ll finish this tomorrow. The bottom line for me, though: I think relative strength in oil exploration and production companies will continue.

There’s no easy answer to this question. I have few qualms about putting a ceiling on the oil price. In round terms, I’d say it’s $60 a barrel, since this is most likely the point at which an avalanche of new shale oil production will come on line. Also, for investing in shale oil companies this number doesn’t matter than much, so long as it’s appreciably above the current price.

A floor is harder.

a first pass through the issue

We can divide the source of oil production into three types. I’m not going to look up the numbers, but let’s say they’re all roughly equal in size:

–extremely low production cost, less than $5 a barrel, typified by production from places like Saudi Arabia

–very high production cost, like $100+ a barrel, which would be typical of exploration and production efforts of the major international oil companies over the past decade or so, and

–shale-like oil, with production costs of maybe $35 -$40 a barrel.

In practical terms, there’s never going to be an economic reason for the low-cost oil to stop flowing.

Shale oil is basically an engineering and spreadsheet exercise. The deposits are relatively small and the cost of extraction is almost all variable. So shale will switch on and off as prices dictate. We know that at the recent lows of $25 or so, all this production was shut in.

The very high production cost is the most difficult to figure out. Of, say, $100 in production expense, maybe $70 is the writeoff of exploration efforts + building elaborate hostile-environment production and delivery platforms. This is money that was spent years ago just to get oil flowing in the first place. What’s key is that for oil like this is that the out-of-pocket cost of production–money being spent today to get the oil–may be $30 a barrel. From an economic perspective, the up-front $70 a barrel should play no role in the decision to produce oil or not. So, dealing purely economically, this oil should continue to flow no matter what.

second pass

First pass says $30 – $35 a barrel is the low; $60 is the best the price gets.

Many OPEC countries (think: Saudi Arabia again) have economies that are completely dependent on oil and which are running deep government deficits. Their primary goal has to be to generate maximum revenue; the number of barrels they produce is secondary. If so, they will increase production as long as that gives them higher revenue. Their tendency will be to make a mistake on the side of producing too much, however. Their activity will make it very hard to get to a $60 price, I think.

On the other hand, shale oil producers who can make a small profit at, say, $35 a barrel may tend to shut in production at $38 – $40, on the idea that if they exercise a little patience they’ll be able to sell at $45, doubling or tripling their per barrel profit.

third pass

Second pass argues for a band between, say, $40 and $55.

Bank creditors don’t care about anything except getting their money back. They will force debtors–here we’re talking about shale oil companies–to produce flat out, regardless of price, until their loans are repaid. This was an issue last year, and what I think caused the crude price to break below $30 a barrel. I don’t think this is an issue today.

There’s a seasonal pattern to oil consumption, driven by the heating season and the driving season in the northern hemisphere. The driving season runs from April through September, the heating season from September through January. February-April is the weakest point of the year, the one that typically has the lowest prices.

If the financial press isn’t totally inaccurate, there are a bunch of what appear to be poorly -informed speculators trading crude oil. Who knows what they’re thinking?

my bottom line

This is still much more of a guessing game than I would prefer. I see three positives with shale oil companies today, however. Industry debt seems more under control. Operating costs are coming down (more on this on Monday). And seasonality should soon be providing support to prices.

Over the past week or so, the world crude oil price has dropped by about 10%–although it is rebounding a bit as I’m writing on Wednesday morning.

I have several thoughts:

–this is the weakest part of the year for crude oil demand, since the winter heating season is over and the spring driving season is yet to begin

–the surprising aspect of recent crude oil prices is not that they are weak, but rather how strong they have been in January and February in the face of a rising rig count in the US and a milder than average winter in heavily populated areas around the world

–hard as this may be to believe, the price drop suggests to me that many traders in the crude oil market are new to the game, and for some reason haven’t filled themselves in beforehand on the basic characteristics of the commodity

–since there’s a direct relationship between the price of oil and the price of oil exploration and development stocks, the current odd price action in the crude market makes evaluating and trading in the equities more difficult

–I’ve built a small position in e&p stocks over the past couple of months, so I’m sitting on my hands. If I owned nothing, I’d be tempted to buy something–although I’d be more comfortable if crude had been gradually declining in price over the past month, rather than exhibiting the panicky behavior of the past week. This is also predicated on the idea that what’s driving crude is thoughts #2 & #3.